Why the Fed Cannot Regulate ‘Systemic Risk’

A systemic risk advisor might help ameliorate bubbles and busts, though not avoid financial cycles.

“Life can only be understood backward, but it must be lived forward.” — Søren Kierkegaard

Thinking about the 21st-century bubble and the financial crisis of 2007–2009 has given rise to the idea of “systemic risk”—and, moreover, to the notion that there could somehow be a “systemic risk regulator.” These ideas are now enshrined in the Dodd-Frank Act, which I refer to as the “Faith in Bureaucracy Act.”

Should there be a systemic risk regulator? No.

Knowing the financial future correctly, much less controlling it, is impossible. This reflects the exceptional recursiveness of financial markets and the resultant fundamental Uncertainty about future financial market behavior. This “Uncertainty,” with a capital “U,” means, according to the classic definition of economist Frank Knight, that you not only do not know the odds of future events, but you cannot know the odds. As Knight wrote, “Uncertainty is one of the fundamental facts of life.”1

“Economic forecasting was invented to make astrology look respectable,” John Kenneth Galbraith is said to have remarked, and, as Alan Greenspan argued in 2009 at the American Enterprise Institute, “Regulation which fails is that which requires forecasting the future.” As the 21st-century bubble made manifest, you can apply mathematics to economics and finance, but that does not make them science. Putting these three thoughts together, there is no hope that a systemic risk regulator could operate successfully.

But we can distinguish between a systemic risk regulator and a systemic risk advisor. The latter might indeed help ameliorate bubbles and busts, though not avoid financial cycles.

As the 21st-century bubble made manifest, you can apply mathematics to economics and finance, but that does not make them science.

Consider this summary of our dilemma by banking expert George Kaufman: “Everybody knows Santayana’s line that those who fail to study the past are condemned to repeat it. When it comes to financial history, those who do study it are condemned to recognize the patterns they see developing, and then repeat them anyway!”2 This witty statement poses a disturbing and profound question. Why do we repeat them anyway? Part of the answer is that the force of the government, including particularly the Federal Reserve, is itself a key source of systemic risk.

Therefore, any meaningful systemic risk advisor has to be distant enough from the government and central bank power structures to be able to speak freely and forcefully to power about the systemic risk that the government’s own actions may be creating. That is why, even if one correctly prefers an advisor to a regulator, an advisory council of government agency heads can never be the answer.

If there were a systemic risk regulator, should it be the Federal Reserve? No.

The history of the Federal Reserve has been marked by periods of severe economic and financial stress and disaster, after which its policies have been revealed as deflationary or inflationary blunders. These were well-meaning mistakes, of course, subject to huge uncertainty as decisions were made in the midst of complexity and crisis. Among these mistakes: the roller coaster of inflation and deflation in 1919-21; the collapse of the financial system and the Great Depression, including the Fed’s 1937 “tragic mistake” of pushing the economy back into contraction; and the Great Inflation and then stagflation of the 1970s.3

Why would we reward with even more power the same agency whose monetary policy stoked the housing and mortgage excesses in the first place?

With the 21st-century bubble, we have a fourth instance in which the Fed made big mistakes. “The U.S. crisis was actually made by the Fed,” argued Columbia University Professor Jeffrey Sachs, and numerous others. Then the Fed was very slow to realize the extent of the problems. Giving the Fed the additional assignment as systemic risk regulator makes the Fed conflicted when combined with its role as monetary manager—and history should make us quite dubious about the Fed’s performance as the latter.

Why would we reward with even more power the same agency whose monetary policy stoked the housing and mortgage excesses in the first place? Senator Jim Bunning of Kentucky is said to have asked Federal Reserve Chairman Ben Bernanke: How can you regulate systemic risk when you are the systemic risk? A great question.

Making this point more academically, David Simpson argues, “Too great an expansion of credit will eventually be followed by a financial crisis and a possible recession …There were 38 crisis episodes between 1970 and 1999 spread over 27 countries. When credit as a percentage of GDP grew at more than 4-5 percentage points above trend, some form of financial crisis followed within one year on nearly 80% of occasions.”

Other governmental sources of systemic risk include Government-Sponsored Enterprises (GSEs) and also federal deposit insurance. Government deposit insurance makes possible and indeed promotes the high leverage of the banking system. A highly levered financial system will always bust from time to time.

A Systemic Risk Advisor

Instead of giving anybody the hopeless task of being a systemic risk regulator, I favor creating a very senior systemic risk advisory function. What would such an organization be like?

The advisor would especially need to supply institutional memory of the outcomes of past financial patterns. It should have both models and memory. It should have a heavyweight board, an insightful and articulate executive director, and a small staff of top talent. It must be free to speak its mind to Congress, the administration, foreign official bodies, and financial actors, domestic and international. It must be free to address the government’s contribution to systemic risk, in addition to that of private actors. The Dodd-Frank Act utterly failed in this respect.

The systemic risk advisor should look first of all for the build-up of leverage, hidden as well as stated, and for accelerating short-term funding of long and potentially illiquid positions that is increasingly considered “normal” and safe. Its purview should be global. Its thinking and analysis should be deeply informed by the financial mistakes and travails, private and governmental, of recent years, decades, and centuries.

A meaningful systemic risk advisor has to be distant enough from the government and central bank power structures to be able to speak freely and forcefully to power about the systemic risk that the government’s own actions may be creating.

The advisory body should be skeptical about assertions that we are in a “new era” to rationalize a bubble. (“This time it’s different” are said to be the most expensive words in the language.) It must be aware of its own limitations in the face of fundamental uncertainty. It should remember that losses often turn out to be, as they have been in the current bubble and bust, vastly greater than anyone thought possible. It should remember at the same time that risk-taking is essential and that the failure of individual firms is not only necessary, but, in the systemic sense, desirable. As my AEI colleague Allan H. Meltzer says, “Capitalism without failure is like religion without sin—it doesn’t work.”4 The systemic risk advisor must also remember that the main point is to keep our long-term growth trend intact, while we cycle around it, with a hoped-for moderation in illusory enthusiasms and destructive panics.

The advisor must seek to identify concentrated points of vulnerability to system failure. If such points develop, sooner or later, they will likely fail. Good examples of such concentrated points of possible failure, which indeed failed at enormous cost, are Fannie Mae and Freddie Mac.5

In sum, a systemic risk advisor, which must be completely separate from the Fed and every other regulatory agency, is distinctly worth a try. But we should not be overly optimistic. It is in vain to think that it or anybody can or could foresee all future problems or prevent all future bubbles and busts. Everybody, no matter how intelligent and diligent, makes mistakes when it comes to predicting (let alone controlling!) the future—no matter how many economists and computers are employed.

Because uncertainty about the future is fundamental, financial mistakes will continue to be made by entrepreneurs, bankers, borrowers, central bankers, government agencies, and politicians, and by the never-ending interaction of all of the above.

Knight wrote: “If the law of the change is known … no [economic] profits can arise.” Likewise, we can say: “If the law of change is known, no financial crises can arise.”6 But the law of change is never known.